Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 44 - Evidence
OTTAWA, Thursday, May 30, 2002
The Standing Senate Committee on Banking, Trade and Commerce met this day at 11:00 a.m. to examine and report upon the present state of the domestic and international financial system.
Senator E. Leo Kolber (Chairman) in the Chair.
[English]
The Chairman: We are continuing this morning with hearings to examine and report upon the present state of the domestic and international financial system. We have two witnesses. First is Thomas S. Caldwell, Chairman of Caldwell securities.
Mr. Thomas S. Caldwell, Chairman, Caldwell Securities Ltd: Thank you for allowing me to make a presentation. I want to address the broader issues affecting our capital markets and, as a consequence, our standard of living. I am hoping to give a context to your present discussion. The concerns are broad, and I will try to give an overview.
Our capital markets have been in dangerous waters for some time. In the smaller, new growth innovation areas, it has become difficult, if not impossible, to finance in single or double digit millions of dollars. The structures are not there to finance smaller companies.
Typically, the larger bank-controlled brokers need $100 million-plus deals to feed their underwriting and distribution departments. Less than a handful of brokerage firms are left, versus 20 years ago, who can do this. Any company of that size that comes to us for financing is directed right away to the U.S.
The other problem is that the larger companies also have capital market concerns. It has become increasingly illiquid for Canadian companies to trade within the context of the Canadian market, partly because we have gotten rid of the auction market environment on the TSE and much of the trading is gravitating upstairs to position trading. As a consequence, the auction market is very thin. Hence, the prices can be moved, manipulated and changed to predicate a larger trade taking place upstairs.
In the old days, you would show a block of stock to a market maker on the floor who would be assured that he would get a sliver, and you would get a fair price. These days, you would never show it to a bank position trader, particularly as an independent firm.
There is an excellent article in the National Post entitled ``The End of Bay Street?'' I would commend that to you because it addresses some of those issues.
Those two issues exist because of the structures we have created. We have created large entities and obliterated the smaller, independent environment.
However, these are technical issues, and I would be glad to discuss them later. They are not fully understood by the investing public. They may have the power to do us in.
The broader governance concerns are the real threat to the system. They are highly visible and clearly understood by the public. It is the ``perfect storm'' metaphor, whereby the technical points are the storm. They can easily do us in. It is the last big wave that may finish us.
The current situation has all the hallmarks of greed, self-interest run riot, manipulation and a lack of investor confidence in public securities markets. We feel it incumbent upon us to act now.
We took out on ad in the national newspapers addressed to the boards of directors and management of publicly traded companies. The absolutely overwhelming response across the country and the investor spectrum was surprising to us. It was not just the disgruntled one-share Sweeney complaining about losing money on Nortel. It was coming from directors and senior people at the larger firms as well. We have to synthesize the problem beyond the basic statement that moral and ethical vacuums do not exist and we do not have a consensus value system.
I want to look at the food chain and trace the problem there. I believe the insane levels of management compensation, usually through the abuse of stock options, is a major contributor to our present circumstance. Once management is granted inordinate compensation levels, the problem starts to work its way backwards. I commend The Financial Post article on this, which I will leave with you. Companies become run by management for management. The focus becomes more stock promotion. The symptoms are an obsession with quarterly earnings, beating the street estimates — General Electric is a good example — burying negatives in statements and reclassifying items to dress up financial statements. IBM is a good example of that. Bad news is delayed. Some stock sales were made between positive outlook statements and sudden disaster in the telecom area. Nortel was a concern in that regard.
This pressure works it's way backward to the CFO, who has a lot to lose, and comes back to the board to approve these levels of executive compensation. The old argument that CEOs are superstars does not hold. I have heard compensation committee members saying that they have to pay the presidents of these companies significant amounts for fear they are going to the U.S.
One bank compensation member said this to me. I said that I live in New York. One thing that I have never heard in New York is that we need to get a Canadian down here to run Citicorp or J. P. Morgan. Those arguments do not wash, in my opinion.
Board members tend to go along with management and the other directors. They forget that they are answerable to the business owners and the shareholders. They see them as an outside force. Connected directors are reluctant to fire management.
In their defence, board members can be hoodwinked. I sit on several boards, particularly U.S. subsidiaries in Canada. We can be snookered without a great deal of effort. Expertise should be either on the boards or available from outside.
On the accounting side, we are seen in the U.S. as the wild west. Only the most sophisticated financial institutions will deal here and none of them know the difference between Canadian and U.S. GAAP. I think research in our securities industry has been abysmal for some years, and investors get what they pay for. If they do not want to pay commissions, research will be paid for by corporate finance. Situations like Merrill Lynch and Mr. Blodget are ubiquitous.
The Tsunami wave that is a threat to our capital markets is happening now. Investors are leaving in droves. They are seeing public markets as a rigged game. Most of them have not made money over the years. The fact that the guardians are not guarding the system is clear.
Investors are seeking out other asset classes such as real estate, boats, condos and cars. We could be approaching a 1930s scenario, where individual investors will lose interest in common shares.
This has ramifications for the institutional investors.
You cannot attack management compensation directly, but clearly, where there is wilful or damaging action, criminal penalties should be pursued more rigorously.
Stock options should be shown as an expense. Shareholders are paying these amounts in diluted ownership. Despite all the studies and recommendations over the years, boards still need to shift their forecast to shareholder interest. Greater accountability is required.
It is easy for me to make suggestions. The honourable senators must have the wisdom of Solomon to find answers.
I think that there should be a requirement for a minimum investment in a company for directors, say $50,000, with no loans to directors allowed and no options for directors. If 20 per cent of the shareholders are unsatisfied, then the same amount should be spent to de-seat a board as the corporation spends to defend it. Make it easier to solicit names to get the 20 per cent. Boards need to feel more vulnerable.
Perhaps there should be a limit to the number of public boards on which a director can serve. Five is not a bad number. Companies should provide funds for outside, independent advisers and auditors to advise the audit committee. Auditors also come under pressure.
You have had several hearings about the audit side of this equation. Accounting flexibility has rendered many statements meaningless as far as I am concerned. I am a user of this data rather than a generator. If you look at changes in auditors' reports, the wording has sort of moved them back. There is little value in book value. There are no warnings of sudden corporate breakdown. Nortel and Laidlaw are clear examples.
When I look at statements, I have to dig through them to find out how they are colouring things. I had a chat with one of the previous CEOs of Air Canada, trying to find out where the real numbers came from. There are two areas in life where creativity is discouraged — flying and accounting, and he was in both of them.
Bell Canada shredded 700,000 annual reports a few weeks ago. Why? Was the blue the wrong shade? Was there a grammatical error? Clearly, the numbers were fudged or there was a problem and the auditors did not approve it.
There is cynicism. Simple, clear statements are needed now. Like the prospectus, the only thing they protect is the standard of living of the people who prepare them.
When I started Caldwell securities in 1981, the only thing relevant to me was cash. As I got away from that simple method into accruals, I lost that sense of control. We have to get back to real cash numbers. There are many examples out there. Cash flow statements are useless because the problem starts with the accrual system.
I met with a representative of tech company recently. I told him that I was only interested in three things about the company. I wanted to know how much money they had in the bank, how much do they have coming in each month and how much do they have going out each month. I care only about the survivability. He took 20 minutes to give me the answer, so he was either lying or stupid. I kind of hoped he was lying.
People more qualified than I will address Canadian GAAP versus U.S. GAAP. I spend much time in our New York office. Americans always see ``different from them'' as inferior to them. There is a strong argument for lining up to some degree. Canada's reputation for quality and conservatism should extend to accounting.
Paul Volker, retired fed chairman, has recommended an independent oversight board to set and monitor auditing standards. Parallel examples could be the Ontario Securities Commission and the I.D.A.
If the regulators do not act, the private sector will. Standard & Poors recently came out with their own standards for analyzing companies. That is the one I will be using. If Canadian companies are not on it, I do not care.
As for securities regulators, we are a bit schizophrenic in our industry. We inflict extreme penalties on small offenders for reasons of optics, yet we let the larger violators walk away with earnings. You can see that within Ottawa city limits, when $23 million of insider trading received a fine of $1 million — not a bad transaction.
A national regulator is needed now. During the Bre-X example, I was a governor of the TSE. I was chatting with the president of Visa in the United States. He said that Canada does not have a securities commission. I tried to explain, and he walked away.
The regional argument for separate commissions does not exist any more because small companies cannot finance. It is not feasible. We have gotten away from that.
If Quebec does not want to be part of it, as we have seen in the papers today, we cannot play that game any more. We have to move forward with a national commission of some kind. If they want to join, fine. If they do not want to join, fine. However, a house divided in this matter will not stand. We must keep that in mind. If they are large enough to have their own commission, maybe they are large enough not to be protected with head offices in Montreal. However, that is another topic.
We are competing internationally and one securities voice is needed to deal with the SEC and other regulators. For example, we cannot get Canadian quotes on U.S. quote machines because we cannot negotiate.
The Chairman: Would you please speak more slowly. The interpreters are asking you to speak slower.
Mr. Caldwell: I am trying to get through my few moments, and I have one more page.
A five-year review will be coming soon with many recommendations. The Merrill and Spitzer recommendations are adequate. The IDA has also come out with more recommendations.
To encourage new issues, bank-owned dealers should be required to provide greater ``selling group'' participations to smaller independent firms. This would allow them to continue in the new issue environment and encourage smaller corporate finance.
On the topic of bankruptcy, when the guardians fail, and they are failing on a regular basis, we have to consider changes that will enable companies to come out of bankruptcy while still preserving value for shareholders. Everybody should take a hair cut in these matters.
I point out chapter 11 possibilities in the States. For example, Laidlaw was widely held, yet the banks demanded full repayment of their total exposure, to the detriment of shareholders. Shareholders should also have an opportunity to recoup some of their losses. Maybe they end up with 10 per cent. Chrysler is a good example here.
Another major collapse will have massive ramifications for our system. I do not want to think what will happen if the $111 trillion U.S. derivative markets unwound, or some of the numerous hedge funds with their high leverage were unhedged, such as long-term capital.
It used to be a joke that the only perfect hedge exists in England, and it is cut twice a week. There are no hedges. There are two liabilities, hopefully one off-setting the other.
The bottom line is that many financial institutions and executives are trying to serve too many masters. The results are that the true underlying customer, the investor, is not being well served, let alone well protected.
Senator Hervieux-Payette: We have not been told about Mr. Caldwell's firm. Give us some information about your company.
Mr. Caldwell: I am a voice crying in the wilderness.
Senator Hervieux-Payette: I like your presentation, but I would like to know who is addressing us.
Mr. Caldwell: We sent a summary. I have been in the investment business since graduating from McGill in 1965. I have worked in Canada and the United States with major firms. I started Caldwell Securities in Toronto in 1981. I am now chairman and manage our New York operations. We are independent brokers.
We are members of the TSE and the IDA. We are also investment managers for high net worth individuals.
I have served as a director of the IDA, and I have been nominated to serve again and will do that in the next while. I am a past governor of the Toronto Stock Exchange. I have been active over the years in speaking out on behalf of shareholders to the best of my ability.
Senator Kelleher: Some of the previous witnesses have been suggesting, probably with justification, that Canada's laws are somewhat deficient in this area. Perhaps our laws are not strong enough. They have been suggesting to us that we should move a little closer to the American system.
One has to stop and think when their system and their rules produced Enron. You wonder why we should move in that direction.
Our committee was in England a few years ago, just as the new British legislation was coming into effect. I am sure that you are familiar with the British structure for handling these matters.
Obviously, the Quebec people have looked at it. Their new system, as mentioned in the paper this morning, suggests that they have. Should we not also look at the British system before we run holus bolus to adopt the American system? Perhaps there is something in there that there we should include as well.
Mr. Caldwell: I like the phrase, ``Keep it simple.'' We live in a North American world. The British are minimal investors in Canada in terms of securities or financings. Our deals are done cross-border with the United States. My bias would be to line up with the United States. We could look at U.K. systems to find those things that have merit.
The securities industry is one of the most regulated anywhere. We have some good laws on the books, but we must enforce them. There are a few gaps. If the IDA fines someone who leaves the business, the fine is never collected. There are many instances of people being fined $100,000 and banned for life. Why would the person pay the fine? He walks away. There must be a system that is enforceable.
We have to look at criminality. I am not talking about sending someone away for five years. Putting a high-end CEO away for two weeks or 30 days would get people's attention as much as fines.
There are laws on the books that we could enforce better. There are gaps, but my bias in regulation would be to lean toward the United States because we invest there and they invest here.
We want Americans to be more focused on Canadian securities. I cannot speak for the TSE, but it would be wonderful to have Canadian companies exposed to brokers in the United States. That means a national regulator to do the negotiating. Otherwise, the OSE or the TSE will attempt to negotiate and both of them are seen as regional or vested interests.
Senator Kelleher: Some of the so-called ``experts'' in this field have been arguing that we should not go overboard with new regulations. We have to be careful not to end up making it so over-regulated that we cannot do business; all we do is add to the expense.
Is this a reasonable concern at this time?
Mr. Caldwell: It is a reasonable concern, because whenever you have disasters such as Enron and Nortel, everyone wants to do something. The issue is what to do, and to what degree. There are real concerns about overkill.
I have noted another matter in regulation over the years. We used to be regulated by the TSE. People might say that is too hand in glove. However, it was effective. If we had a problem or we could perceive a problem coming, we would call the TSE and ask, what are the capital connotations? What does this mean? We would commiserate and discuss. There was more discussion. That was effective regulation.
When you move to having regulators work on the basis of ``gotcha,'' people are not going to tell them anything. Even though there might be more rules, we have lost a sense of real industry understanding in dealing with what is substantive.
There are matters that we have to deal with in accounting, securities regulation, bankruptcy, compensation and board accountability. Those are the areas at which I would look.
Senator Angus: I found your presentation outstanding. I was intrigued earlier today about why you were coming and whom you would be representing. We went on the Web in my office earlier and learned much about Caldwell. I understand that you are one of the last remaining ``independent,'' if I can say that, securities firms. You pride yourself on being independent of the big banks.
Would it be fair to say that one of the reasons you speak out on these issues so unequivocally, and in some cases bravely, is because you have a vested interest in seeing that our capital markets do not encounter the perfect storm and get back to reasonable health?
Mr. Caldwell: Absolutely. It is a convergence of self-interest and national interest. We have opportunities as an independent firm. Our larger competitors respect that, and they have sometimes been supportive. When we stood up for shareholders, one of the bank firms did business with us to help us.
Being independent, we do not do underwriting or financing for people. We see that as a conflict in managing money. We have an opportunity to speak out on issues. These are industry issues that are important for the survival of any firm in the securities business, including our own. We have always taken the side of the investor. Our intent has been always the same.
Senator Angus: I salute you for doing that. It is key that people with your credibility speak out. Your independence enables you to do that more than others.
On your Web site is an economic review and forecast in which you deplore the current situation. Even though there is some bullishness returning to the economy, at least according to the Governor of the Bank of Canada, your colleagues have outlined that there is a lack of credibility and investors are suspicious of corporate accounting practices. They do not trust the numbers. You conclude by calling for a return to a broader-based economic recovery, coupled with more conservative accounting as leading to better equity markets in the future.
``Conservative'' is one of my favourite words. What do you mean by that? We had an interesting session yesterday with two experts. Certainly I got a little confused about U.S. GAAP, Canadian GAAP, FASB, international FASB and accounting standards boards. Another witness this morning will advocate international accounting standards as opposed to the U.S. or Canadian ones. I am confused.
Could you comment on that, coupled with explaining to us what you mean by ``conservative'' accounting?
Mr. Caldwell: Stock markets and the economy have decoupled. We are seeing good economic numbers, but market people are saying that they do not care. They do not believe what is happening. There has been a separation of the two.
Markets have been relatively high in accordance with published earnings over the last little while. There has been a gap. The feeling is that either the market goes down to what is reasonable, which might be 7,000 on the Dow relative to earnings multiples, assuming you can accept those, or trade in a range until earnings catch up. However, all of a sudden we discovered these earnings are not here, but over here. Everyone is now ``getting religion,'' if you will, and getting back to shore. Auditors are tough. I sit on several boards, and managers are not getting what they want from the auditors. That will happen.
Senator Angus: When you say they are ``down here,'' you mean the quality of earnings as reported is getting better?
Mr. Caldwell: We have discovered some error in there, which has been taken out. They are being lowered as everyone is trying to get back onside and not be too aggressive on the accounting side. The issues of GAAP, Canadian and U.S., and international standards, are complex. Frankly, they are beyond me. I am a user of this data and I just know when they are fudging. Going back to that tech company, my question was, how much money do you have? Are you survivable? There is one question for Nortel: Is that company survivable? That is my concern. I want to look at that, but we do not want to get into stock recommendations here.
I will leave you with one thought. The bulk of our trade and business is with the U.S., not with Europe or anywhere else. It is with the U.S. I would encourage this committee, or other committees, to keep that fact in mind. Our American cousins have a sense, real or imagined, that if it is not the same as they are using, it is not as good. One of my partners, who is about as blind as I am, was recently in Nashville. He said, ``You guys should have different coloured money like we do. It is vastly superior.'' He could not convince them. If America does it this way, it has to be better. We have to recognize that reality. That would be my only broad-brush suggestion.
Senator Angus: I understand the logic of that. That is certainly where Professor Thornton was coming from yesterday. This is our world. This is where our trading takes place and where our capital has to be raised. We had some background information for this study in which we were given financial statements and the balance sheet according to both U.S. GAAP and Canadian GAAP. There might be 40 per cent difference in the bottom line. I found that very telling. The poor retail investor, whom I hope you are representing when you say —
Mr. Caldwell: We hope they are not poor now. Every time I have talked with a U.S. investor, the topic of aggressive Canadian accounting has come up. ``You cannot trust the numbers up there.'' They see us as the bad guys. I tried to convince them the Australians were the bad guys, but they see them as us when it comes to this. That would be my encouragement. It is the number one topic in the U.S. If we want investment here to go back up, we have to line up with those rules. Forget about nationalism and regionalism. Let's get in the big game.
Senator Angus: I am a member of the board of Air Canada, and I am also on the audit committee. Could you repeat what you said? I was reading my notes when I heard you quoting one of our former CEOs.
Mr. Caldwell: As you know, your company had not bathed itself in glory over the years in terms of earnings.
Senator Angus: It was not a question of quality. There just were not any.
Mr. Caldwell: That was gleaned from other sectors, either sale and lease back or sale of Galileo, in this instance.
Senator Angus: That was Senator Fitzpatrick's fault, of course.
Mr. Caldwell: It does not usually take me as long to offend people as it has at this meeting. I believe that Galileo was brought in as earnings. Why would you want to build up your earnings just before you were going into negotiations with pilots? I could not understand that, but there is much I do not understand.
Senator Angus: I want to repeat this to Robert Milton later on.
Mr. Caldwell: There are two areas in life where creativity is discouraged, flying and accounting. You are in both of them.
Senator Banks: I was delighted to hear you say that managers are not getting what they want from auditors.
Mr. Caldwell: That trend is starting. I can see it in the companies in which I am involved. Frankly, the auditors are scared. Everyone has to feel a little vulnerable in this process.
Senator Banks: There is good reason. This is a hypothetical question, but it was twigged by something that you mentioned, and it has been raised elsewhere. If we introduced a regime based on the American model of GAAP, but raised the bar higher and made it very stringent, I know that some economic sectors would fall into a panic. Do you think that that could, after some short-term pain, be a long-term gain? Would becoming the ``good housekeeping seal of approval'' attract investment business to Canada?
Mr. Caldwell: I have been wrestling with that question over several days. No one ever regretted buying quality. What if we were the quality standard? What if we were a notch above others and people said, ``Yes, that is the place to be''? It sounds all right in theory, but in practice, it comes back to that money of different colours again. It is clearly superior. My suspicion is that we would not be appreciated. I like the idea of Canadian quality. I live and work in New York and compete with some tough guys. We can do it down there. I like the idea of Canadian conservatism and quality, and I would like to see it in many areas. Let's get involved in that.
My thinking is that we are sometimes dealing with a sense of pride. I do not want to be U.S. bashing, because if we could pick our neighbours, we could not pick better ones than the Americans.
Senator Banks: I am not talking about pride.
Mr. Caldwell: It is their pride. If it is different from their way, it is not as good. It could be detrimental in practice. I have seen both sides of that issue.
Senator Meighen: Take your time, Mr. Caldwell. This is a most interesting session.
Mr. Caldwell: I do not want to be a fast-talking broker here.
Senator Meighen: It is unusual in Ottawa, as you can appreciate, to hear frank talk. This is great. Perhaps our fundamental mistake was to allow bank-owned dealers. What are your suggestions for unscrambling the omelette? The only thing I could see was to get down on bended knees and ask them to be good enough to include some independence in their syndicates. It does not seem to be a fundamental solution.
Mr. Caldwell: It is not, but it is a partial solution.
I do not like to sit before you and say, ``I told you so,'' but I spent a lot of time and effort on the repeal of the act in the United States, allowing commercial and investment banks to remerge. Canada followed suit. I do not know that we had much choice there. I am not afraid of big banks or bank mergers. That genie is already out of the bottle.
Senator Meighen: You should have come here a few years ago.
Mr. Caldwell: I was not asked.
Senator Meighen: You have an open invitation.
Mr. Caldwell: However, I believe that that was a devastating mistake for Canadian economic development. It literally obliterated the ability to finance at the lower levels. I do not care if companies say, ``We have a venture capital arm.''
We no longer have the ability to finance new enterprise at capacity economic levels. The system has ceased to be one of giving investment advice and is one of garnering deposits.
In my first presentation, I talked about mathematical set theory: If you do this, that will happen; if you do this, that will happen; if you do both, the results can be over eight miles away. I remember the answer given to me at that time was that the four pillars would stand; that is, insurance companies, trust companies, banks and brokers. Clearly, three pillars were made of silly putty. However, I do not think we can undo the situation. It is here. There are many decisions in my life I would like to take back, but I cannot. I have to go forward, and we have to go forward with what we have. It has been quite damaging. How can we tinker with it?
Senator Meighen: What impediments, if any, are there to more Caldwell Securities type companies coming into being? Do they have trouble attracting business because of the overwhelming presence —
Mr. Caldwell: You have to understand that a bank can spend more on advertising today than we can spend in a year. They have massive exposure. I spoke to the committee on tied selling some years ago, which, you may recall, the banks said did not exist. Now they have rules, which are not being enforced, in that regard, but they also have a policy statement. When a fellow comes in for a loan, they say, ``We would love to give you a loan, but we would like to deal with your total banking. Can we handle your RSP, your car, your mortgage and your life insurance?''
It is like Toronto, which is a big black hole sucking everything in, and it is not good for the country — the banks are large black holes sucking everything in. There will always be suspicions about what happened to Eaton's, which had been in business for 150 years and then got into trouble with its banks. Bank-controlled firms did an underwriting and sold $150 million in equity to unsuspecting shareholders in a company that was an icon. Less than a year later, it is bankrupt and they have lost everything. That is the reason Glass-Steagall was put into effect in the U.S in 1933. I do not know how we get there.
I get up every morning and compete with people who have 10,000 times our capital and 10,000 times our employees. I believe I can take them on, but it is still a tough business to get into. Again, every regulation that comes down the line does not hurt the banks; it hurts the independent firms. Every time I see a new regulation, I look at it and say, ``How are they trying to get us now?'' They have bodies of people to do this.
I was looking at my report here and I felt it was a bit scrambled because I do have a day job — I manage people's money and I have to spend time at that. We do not have the people to send here to Ottawa. When I came before the committee looking at tied selling, I felt like ``Mr. Smith goes to Washington'' when I saw how powerful the bank lobby was here. I do not have the time or the skilled staff to do that. It is a tough game.
As Solzhenitsyn said, there will be blades of grass coming up through the concrete. There are some outstanding independent firms out there. The bank firms are not that bad either. They do what they do. The problem is that they are deposit garners and mass marketers of merchandise, as opposed to being in the advice business.
Senator Meighen: I share your view on obscene levels of compensation. I do not see how anybody needs to take home $25 million. To use Senator Angus's words, I consider myself a ``conservative.'' The only argument I ever heard was that if this is what heads of large corporations are being paid and you want the best, you have to pay what the market is paying.
Mr. Caldwell: Chainsaw Al was not worth $50 million when he demolished Sunbeam. There are no superstars. Make no mistake that management of any company is a team sport. Even in a firm our size, with under 100 people, it is still a team event.
You can take a look at the Post survey. We have some instances in Canada — I will not mention the names — where CEOs were paid more last year than their predecessors were paid during their whole working career with the same company, adjusted for inflation. That is a joke! If you are going to pay me $85 million to do my job, I will take it. The people responsible are the boards of directors and the compensation committees. The argument about compensation for superstars is bogus. There are many bright people who can do a good job of running companies in this country for a paltry, single-digit number of millions.
Senator Meighen: There are some superstars who can do a bad job.
Mr. Caldwell: They tend to because the danger is that you believe the press clippings.
Senator Meighen: You mentioned on a couple of occasions that, because of the uncertainties hanging over the market and the ``scandals'' that one reads about almost daily in the papers, investors are leaving in droves. I do not doubt it, but do you have any data to support that? The fact that mutual funds are ever present, particularly in our market, accounts for a lot of investors indirectly.
Mr. Caldwell: Indeed. It is primarily anecdotal. I talk to many people in our industry every day. If you talk to one person, that is anecdotal. If you talk to enough people, that is what is happening. You can take a look at the mutual fund business, where there are net redemptions right across the board. The investors are leaving in droves, but it may not be permanent.
I was talking to a client in New York recently who said, ``We are really upset about markets, so we bought real estate and we feel better. The money will be invested in something. We are not going to look at common shares or corporate bonds because we do not trust the numbers.'' All of a sudden, something comes out of the blue. Laidlaw was doing fine, and then all of the sudden, its numbers were not good. If we wanted research on waste management, all we should have done is watch The Sopranos, because the accounting did not help anybody. They did not warn a single person of what was happening. The investors have not made money and they see the scandals going on and the inordinate compensation, so they are going for different asset classes.
Senator Meighen: Just for clarification, did I hear you say that, even if Quebec wanted to maintain an independent commission, if the rest of the country got together, that would go a long way towards solving the problems you perceive today?
Mr. Caldwell: I think we have to do that. We cannot fool around with this any longer. This country has spent its history trying to dance around this thing. We have to move forward. We are no longer in a national competition, trying to beat up on each other. We have bigger competitors staring at us. If we do not address that, we will have a problem. One of the solutions is a national securities commission. I would hope and pray that Quebec would join us at some point — although maybe not.
If there were a national commission in Canada that was recognized on an eyeball-to-eyeball basis in the States, I think Quebec might want to line up with that at some point in the future. They might have some good points that we could share. We have to move forward. We cannot stand still trying to get them to join. We have to file in Saskatchewan because we have some investors out there. The problem is that we have to go through this exercise. It is costly for anybody to register in all the provinces. We want a board that is responsive on both a geographical and an industry-wide basis, and not just to the big kids.
Senator Meighen: I will give you a free political tip: Suggest that the national commission be located in Montreal and you might carry the day.
Senator Hervieux-Payette: I would suggest having it in Ottawa as a compromise, and you probably need to make sure they do not wine and dine with all these big guys in the financial sector in Toronto.
Mr. Caldwell: You want some of that to happen because you want feedback. I notice that the RCMP fraud division is in Orillia — a hotbed of fraud, no doubt — but the action is in Toronto. Let's put them where the action is and not distance them. However, we are jumping ahead of ourselves.
Senator Hervieux-Payette: Where is it located in the United States?
Mr. Caldwell: The head office might be Washington, but there seems to be a whole gaggle of people floating around New York.
Senator Hervieux-Payette: I wanted to ask about this commission, because we have one in Quebec. I was a director of a small company. Eventually, I was not happy with the behaviour of the management. I am no longer a director, of course.
As directors, we have a fiduciary duty.
When I noticed there were some irregularities, the stock exchange and the commission told me they were unable to do anything. One has to ask oneself, why then do we have a commission?
There had been an enthusiastic promotion of the stock and its value rose. I lost sleep over it because I thought it did not reflect the activities of the company. I tried to convince management to stop the promotion. As I said, we have the two institutions and I asked them to intervene. If my only option is to resign, I am not serving the interests of the shareholders.
If we are going to have a national commission, how can the activities of which I speak, such as with Enron, be stopped?
Mr. Caldwell: I have to say that if a director of a company approaches a regulator about the trading of a stock and the regulator, in the particular instance you mentioned, was the Toronto Stock Exchange, I would be stunned if they did not respond with a degree of vigour. Their responsibility is to see to the orderly trading of a security and the visibility of the available information.
Commissions have tended to be behind the curve when it comes to the actual trading of a stock. It is usually when something breaks loose and there is a problem, and, not very often, media exposure, that forces them then to act.
A trading body — I do not know the circumstances — should have given you a better hearing because then you are faced with the conflict of resigning and leaving people swinging in the breeze.
Senator Hervieux-Payette: I hope we can prevent that in the future. As far as I am concerned, the promoters are dangerous and do not take into account other ``members of the family.''
Mr. Caldwell: We are turning many managers of major companies into stock promoters through these inordinate options.
Senator Hervieux-Payette: There is an interesting comment on page 7 with respect to shareholders versus banks. There was a transaction involving the refinancing of a company in Toronto, CallNet, where loans were negotiated and as a result, shares in the company were acquired. Do you think that banks should bear more responsibility to the shareholders, that there should be a more balanced approach to debt so investors can be protected? Is there a model for such an approach?
Mr. Caldwell: There is. This is end game. When the guardians have not guarded and the system breaks, then what happens? What has happened traditionally in Canada is the creditors dive in, and on the basis of the priority of security, get some or all of their money back. Always, the common-share holder gets nothing.
Let us take Laidlaw as an example. Laidlaw was probably one of the most widely held companies in Canada. Many people held Laidlaw stock within mutual funds, some of which were controlled by large firms that were controlled by some of the banks, for example. Banks — maybe not the same banks — made loans to these companies. As soon as Safety-Kleen, the U.S. subsidiary, said the books were not relevant, it was tantamount to putting the company in bankruptcy. The management says, ``We will have a strong company coming out of that.'' They will not take a haircut; they will keep their jobs, except Mr. Bullock, who was then the president. It looks as if the banks will get a good chunk of their money back, and the shareholders get zip. That is wrong. When the guardians fail, everyone should take a degree of loss. There should always be the willingness and the desire to preserve some value for the residual owners of the business because they have no control.
Laidlaw is sound at this time, but the common-share holders wound up with nothing. At one point, they were going to cancel the common shares. I do not know how that can be done in law. Chapter 11 in the United States does allow a company to go into a restructuring mode, as Chrysler did years ago, and the shareholders made a good chunk of their money back after this interim receivership. I am not a lawyer, but I would ask that some consideration be given to an intermediate phase that can preserve common-share holder value.
The common-share holders of Laidlaw are distressed about this. They are trying to get a proxy solicitation to unseat the directors and come up with a new negotiation. However, they do not have enough money to do it because the money left in the company is going to be used to fight them. Boards have to be made to feel more vulnerable; then the company should pay for that solicitation. I believe the cause of the Laidlaw common-share holders is just.
Senator Hervieux-Payette: You say boards have to be made to feel more vulnerable, but should we not properly say ``more accountable''? They should represent the shareholders.
Mr. Caldwell: Accountability does not mean anything unless there is a penalty attached.
The accountability, the responsibility, should result in their being sacked. It is extremely difficult to unseat a board of directors. We have to make that easier so that they feel vulnerable.
Senator Hervieux-Payette: You mentioned that we must be ``green,'' like our neighbours, with our money. Your report recommends that stock options be realistically reflected in the books. That is not green; it is probably yellow. How do you reconcile that?
Mr. Caldwell: The United States is moving to do that.
Senator Hervieux-Payette: You are saying it is almost a fait accompli.
Mr. Caldwell: That is one of the recommendations, along with an independent board overseeing auditors, much in the same vein as the OSC and IDA. Past Chairman Volker has recommended this.
Senator Hervieux-Payette: You made a comment we should more or less mirror the United States. This comparison is being made in all committees on the Hill dealing with legislation and regulations. There is a common approach with our American friends. You will understand that we resist this so-called ``harmonization process.''
Yesterday, one of the witnesses said that we do not want to go the way of New Zealand or Australia. We want a reliable system. I am not saying that all the Europeans will want to come here, but there is money in Europe and it is being invested in the U.S., probably for the very reasons you mentioned.
Mr. Caldwell: They are looking for a safe currency haven. I was in England two weeks ago. They do not have Canadian investments or interests in the Canadian market. They come to North America to buy North American companies.
Senator Setlakwe: You mentioned the lack of venture capital and start-up capital for small enterprises and the lack of interest of the banks in this field. Do you think there are government institutions that can play a role in this area?
Mr. Caldwell: No.
Senator Setlakwe: I have in mind the Federal Business Development Bank.
Mr. Caldwell: They are going to help around the edges. Going through the red tape with any government program is too much aggravation to bother with. You have to be dealing in an entrepreneurial environment. It is not that the banks will not do it. The banks are not structured to do small financing. They need $100 million-plus to feed their distribution and underwriting machinery. You have to recognize that.
Labour-sponsored funds help here and there, but I have not seen, nor can I conjure up, a federal program that would work because you have non-entrepreneurs dealing with entrepreneurs. Financing of smaller companies requires an entrepreneurial, not necessarily a bureaucratic, vision — not that one is worse than the other. They are just different. I do not know how to do that.
The Chairman: Thank you for your presentation, Mr. Caldwell.
Our next witness, Mr. Guy Legault, is from the Certified General Accountants Association of Canada.
[Translation]
Mr. Guy Legault, President and CEO, Certified General Accountants Association of Canada: It is with great pleasure that I appear before you this morning on behalf of the Certified General Accountants Association of Canada.
[English]
I would like to introduce my colleague, Professor James Gaa, FCGA, Ph.D. He is a professor of accounting and management information systems at the University of Alberta, and was a Canadian board member of the International Accounting Standards Committee, IASC, from 1997 to 2000. In addition, Professor Gaa served as a non-voting member of the Accounting Standards Oversight Council until January 2001.
The Certified General Accountants Association of Canada is the national association of more than 55,000 certified general accountants and students enrolled in programs in Canada, Bermuda, the nations of the Caribbean, Hong Kong and the People's Republic of China. The association advances the interests of its members and the public through national and international representation and the establishment of professional standards, practices and services.
It is my understanding that members of the committee have received copies of a submission that CGA-Canada prepared in connection with our appearance before the Accounting Standards Oversight Council on May 3. That submission is a propos in light of your interest in many of the issues that the council was seized of vis-à-vis post-Enron fallout. I do not intend to repeat everything contained in that submission. I propose to touch on some of the key points covered in it, and then leave as much time as possible for an exchange of views.
You will have noted from our AcSOC submission that we have addressed matters pertaining to accounting standards in some detail. We have also touched on a number of other matters that have arisen out of the Enron episode that we feel are equally relevant because, as accountants, we believe we have an obligation to examine and comment on what I am calling ``collateral issues'' arising out of that experience.
[Translation]
An honest analysis of the Enron fallout must take into account all related issues, because it is clear that we, accountants and auditors, do not work in a vaccuum.
[English]
In reading the flood of commentary from the Enron affair, we all agree that concerns extend beyond the obvious accounting standards issues to include matters such as the possibility of conflict between the role of auditor and consultant and questions relating to the extent of checks and balances in the realm of corporate governance. Though we must take care to ensure against prejudging the outcome of various legal proceedings concerning Enron, a preliminary case can be made that all these subjects seem to have been bound up in a tangled web of conspiracy and deceit.
[Translation]
At the heart of our proposal lies the following: as a whole, the profession must examine the fallout of the Enron affair and take corrective measures to serve the public interest. This should be our first priority.
[English]
In a poll conducted on our behalf by the POLLARA research organization earlier this month, over 45 per cent of respondents identified government as the primary body responsible for instituting reforms to ensure that an Enron-like phenomenon does not occur in Canada.
It is no secret that our organization has been urging public debate on enforcing and setting accounting standards since 1999. It is a shame that it took something as damaging as the Enron affair to kick start that debate.
Nevertheless, I wanted to congratulate this committee for conducting these hearings as a precursor to an in-depth analysis of the events that led up to Enron and proposals for action to make sure that Canadians are protected as much as possible against similar occurrences.
The core value underscoring CGA-Canada's position is the proposition that as a profession, we need to examine the Enron fallout and propose remedies that serve the public interest. That must be our highest priority.
We also believe that the issues go beyond the weakness of specific accounting standards. They encompass the standards we should have, as well as the needs of various types of reporting entities. The issues include the standards we will need in the future and how those ought to be set. We must come to grips with the manner in which we operate our accounting businesses and how we separate our private profit motives from our public obligations.
It is also about how the corporations we serve — large, medium and small — conduct their affairs and how citizens involved in commerce are required to separate their public and private responsibilities.
We believe that the accounting profession can and must improve. Now is the time to carry out a fundamental re- examination of the nature of accounting standards and the process of setting those standards.
The Enron affair has provided an opportunity for serious public policy discussion, the goal of which should be to devise an appropriate response to legitimate concerns that have been expressed by investors, creditors, preparers, regulators and the general public.
On the specific question of standards, it is our contention, as we have argued for some time, that the U.S. accounting standards regime, with its heavy reliance on narrow, prescriptive rules rather than broadly based principles and professional judgment, contributed to the company's collapse. U.S. standards foster a ``rulebook'' mentality: be on one side of the rule and it is okay; be on the other, and it is not.
This approach can contribute to obscuring the true financial picture of a company, as was the case with Enron. We must adopt the best of the best. To that end, we think that the accounting standards developed by the International Accounting Standards Board, IASB, provide a solid foundation for a universally accepted set of accounting standards.
There is significant opinion building in Canada, and elsewhere, for the adoption of high-quality global accounting standards. Bill MacKinnon, CEO of KPMG, recently said that he hopes the profession will move globally towards the best of the best proposals being put forward by the IASB. Sir David Tweedie, Chairman of IASB, observes that Enron provided an opportunity to look at the issue of high-quality global international accounting standards and notes that Canada has a leadership role to play in this move.
As for public opinion, the POLLARA research that I referred to earlier reveals that 58 per cent of Canadians would prefer that Canada move closer to the IASB standards, as compared to less than one-fifth who would prefer Canada to move its standards closer to those of the United States.
It has been argued that moving to IASB standards will result in a negative impact on Canada because of our close economic ties with the U.S. Thus, Canadian enterprises that are SEC registrants, either directly or as subsidiaries of U.S. parents, would find it more efficient to use U.S. GAAP only. However, the impact on other Canadian enterprises of switching to U.S. GAAP is unknown.
Since it seems clear that both the U.S. and Canada will eventually converge on international standards, adopting U.S. GAAP would put an extra burden on non-SEC registrants.
The debate should not be about whether we move to international standards, but rather when and how. Research must also be designed to help us understand how to facilitate the transition. In that regard, CGA-Canada has commissioned the Institute for Collaborative Government to look at new and innovative models that could be used to set, apply and enforce accounting standards in Canada.
The results of that study will be made publicly available.
Even if ISB standards are adopted globally, individual countries will have to have systems in place to adapt those standards to accommodate local conditions. In that regard, we believe that the status quo in Canada will also require adjustments. We think that the days of the profession creating and enforcing its own standards are no longer tenable. The crux of the problem stems from the many hats worn by accountants, especially in Canada. In this country, accounting standards are issued by a committee composed largely of practising accountants, and which is staffed and funded by only one member of the profession.
Then accountants, as employees and/or consultants, prepare the financial statements. Finally, accountants, in their capacity as auditors, examine the financial statements and report on their conformance to the standards set by accountants and followed by other accountants.
To make matters more difficult, accountants acting as management consultants advise company accountants on how to apply the rules other accountants have devised. At the very least, the appearance of a conflict of interest ought to give us pause.
Therefore, we recommend that in concert with a move to adopt international standards, and in the interests of propriety and integrity, a body operating independently and at arm's length from all professional accounting bodies needs to be vested with the responsibility for the setting and oversight of accounting standards in Canada.
Let me give you a specific example of why we believe this kind of fundamental change is necessary. It is the example of stock options. It is now widely recognized that stock options should be expensed. Yet the Accounting Standards Board here in Canada has been reluctant to do the right thing for fear of losing a so-called ``level playing field'' with the U.S.
In these uncertain times, when the public is demanding transparency and economic leaders from the around the world such as Federal Reserve Board Chairman Alan Greenspan are weighing in on this issue, we must show courage and do the right thing.
Turning back to one of the central issues in the collapse of Enron, whether it reveals systemic flaws in the accounting industry, in that the same firm provided both audit and consultancy services, there is some evidence that the consulting/auditing relationship was a factor in the audit failure. For example, it has been revealed that Andersen teleconferences specifically addressed the accounting problems in the context of the fact that future audit and consulting fees from Enron would grow to U.S. $100 million.
In the case of publicly traded entities, there is a responsibility to the investor, who relies, in whole or in part, on published financial statements when making investment decisions. There is also the duty owed to creditors, who lend funds based on published financial statements.
At the same time, we do not believe that a one-size-fits-all approach to this factor is necessary or productive. As you know, the small and medium-sized sector is a significant driver of jobs and growth in the Canadian economy. Any reforms to the accounting system that are undertaken now must address those needs.
For example, when considering proposals to protect against possible auditor conflict of interest, that is, between auditing and consulting services, we must consider the unique relationship between an SME and its accountants. In the case of a privately held SME, the accountant typically provides a broad range of services to the client.
We believe that limiting consulting activities of SME accountants to non-auditing clients would not serve this sector well and would be unnecessary, because there is no broad public interest. However, the same dynamics do not hold with respect to publicly held companies, in particular, those that are very large and widely held.
Finally, I want to turn to the theme of corporate governance. This is a matter that has gained much attention in the United States and Canada during the past years. Shareholders' rights groups, think-tanks and other independent bodies have collectively provided a solid stream of advice to companies, their managers, shareholders and directors, most of which seems designed to enhance transparency while being mindful of the corporate obligation to grow shareholder value.
Many corporations have taken independent action to shore up the mandates of boards of directors and provide them with new tools to perform their important tasks. In the case of Enron, and there are other examples, legitimate questions are being asked about the role of the board in general and its audit committee in particular. Were these people complicit or simply ignorant? How could they have fulfilled their responsibilities to oversee the affairs of the company in a manner that would have prevented its collapse?
The composition of Enron's audit committee was problematic. Initial reports indicate that the members of the committee lacked the experience and background to effectively fulfil their oversight role. It appears that the committee was chosen so as to minimize the likelihood that management-imposed irregularities would be ``found out.''
As Finance Minister Paul Martin noted in a speech on May 21 to the Canadian Venture Capital Association and the TSE, ``Enron's audit committee met 5 times last year while its compensation committee met 10 times.''
It is not obvious that external oversight would have detected and/or prevented these actions. However, the auditors should have recognized the weaknesses of the audit committee and questioned its composition. Likewise, a reading of board minutes by the auditors would have revealed that management had suspended the company code of conduct, which should have triggered something in their audit program.
CGA-Canada supports recent initiatives to place greater emphasis on the auditor/audit committee relationship. New recommendations from the Assurance Standards Board would require that the auditor communicate with the audit committee on matters associated not only with the acceptability of the accounting policies adopted by a company, but also their quality.
Are these policies the appropriate ones for the company to adopt in the circumstances? Have the circumstance under which existing policies were implemented changed? Are new policies now in order? The bottom line is that there must be some formal assurance that audit committees are composed of competent individuals who are disposed to probe into the financial information that is provided to them by company management and the auditors they have retained.
It may well be that the Canada Business Corporations Act, which as this committee knows better than most was only recently amended, may need to be re-opened to build in provisions that will attend to these problems in a responsible and pragmatic fashion.
This brings me to the end of my formal remarks. I realized that I have covered a great deal of territory. In the time available, I may not have been able to do justice to every item that I have addressed. These are complex issues and no single individual or organization has all the answers.
[Translation]
CGA-Canada does not have all the answers, but please understand that we take these issues very seriously. We intend to do our share to ensure that the accounting profession recovers and even improves its reputation, which is based on integrity and professionalism.
[English]
I can assure the committee that CGA-Canada takes these issues seriously. To the extent that we can work with you and other parliamentarians to reform our laws and systems in a manner that better protects the interests of Canadians, we are at your service.
Senator Angus: I would like to start my questioning on page 2 of your submission.
You state: ``Nevertheless, I want to congratulate this committee for conducting these hearings as a precursor to in- depth analysis of the events that led up to Enron...''
Are you suggesting we are not doing an in-depth analysis? If you do not think we are doing one, who do you think in Canada is?
Mr. Legault: I do not suggest that. On the contrary, we are grateful that the Senate Banking Committee is looking at these issues. Since 1999, we have been asking for a full public policy debate on the accounting standards side of the matter. We are very pleased.
What we find right now is that all the players in the financial community are struggling to improve and to find the answers to some of the challenges that have come to light, especially after Enron.
We need a place in Canada where we can bring those answers. We need somebody to ensure that we put all the pieces of the puzzle together. We believe your committee is the place. We welcome your work. We think what you will do in that regard will be extremely important.
Senator Angus: Can we strike the word ``precursor'' and put in its place the word ``synthesizer''?
Mr. Legault: Be my guest.
Senator Angus: I want to talk to you about standards. You are unequivocal in recommending that we move to the international standards rather than those of the U.S. or anybody else. You were sitting here earlier when you heard me say that I was confused. You also heard Mr. Caldwell say that he too is confused.
It seems to me that this is fundamental. If I understood you, you were saying that the regulations in the U.S. are part of a rules-based system, and the U.K. and other countries operate more on a judgment-based system. We heard that about bank regulations as well. In London, we heard that they have trouble with the big American banks because they still want to use their own system. Therefore, the international American banks operating in the London market are subjected to two sets of regulations because they have to be reviewed under U.K. laws as well as their own.
I do not see why there should be so many different kinds of accounting. Accounting is accounting. It is the way you reflect financial data. The standards of the IASB, the FASB, or any of these other acronyms, overlap greatly, do they not?
I do not think today people are married to U.S. GAAP or Canadian GAAP or IASB. Correct me if I am wrong, but people are saying, ``We have a big problem with the way companies are reflecting their financial information.'' We are told it is particularly lax here, and that if you follow Canadian GAAP and FASB, you can get away with not showing a significant amount of material, especially off-balance sheet stuff.
Rather than moving to IASB standards, which, for the reasons Mr. Caldwell explained, makes it awkward in dealing with U.S. investors, would you not consider one new standard for everyone? Is that not what will come out of Enron?
I hear people in the U.S. talking about wholesale changes in accounting standards. Certainly you are advocating that there must be a change. All the witnesses say that there must be more accurate and conservative accounting.
Mr. Legault: You are saying the same thing we are saying — that the world needs a set of global standards. There has been an international effort to create that set of global standards. The Americans have been hesitant to join in right away, but they have been looking at the issue because they also believe that we need a set of global standards. They would like it to be the U.S. standards, but they realize there will be a need to converge.
The former Chairman of the Federal Reserve Bank, Paul Volcker, said recently that we need a set of global standards and convergence will occur one way or another. The issue is what should we do in the meantime. We look at the situation and we say, ``Our Canadian standards used to be, and still are to some extent, principle based and judgment based, the same way that the international standards are.'' On the other side, the U.S. standards are rule based and very prescriptive.
It makes much more sense for Canada to move to international standards, given that we have the same underlying philosophy. That makes for an easier transition.
Otherwise, we would make a first transition to the U.S. standards, and since everyone agrees that they will converge on an international set of standards, there will have to be a second transition. One senator asked whether this is a question of short-term pain versus long-term gain. I suggest that is correct. Why do we not go the international route from the beginning?
At the same time, we can see the size of the U.S. equity market. The chairman of the New York Stock Exchange was telling us a few years ago that the U.S. equity market had been decreasing in size by approximately 11 per cent over a 13-year period. That market is growing, but not as quickly as the total world capitalization. Therefore, the question of which way we should go is valid.
Senator Angus: You mentioned that your submission today is basically the same as the one you recently outlined to the Accounting Standards Oversight Council. Yesterday, some of us asked who they are, what authority they have and who appoints them. We were told that the accountants bring in a couple of priests and the odd senator and try to whitewash themselves. What authority do they have? What is their role in trying to fix this problem?
Mr. Legault: That is an interesting question. It goes back to our second point about an independent standard-setting approach in Canada. The standard-setting process has been delegated to the Canadian Institute of Chartered Accountants through the regulations under the Canada Business Corporations Act.
In an effort to put some independence into the process, because this is the way the world is moving, all of the industrialized countries, except Canada and Denmark, have separated the role of accounting standard setting from the accounting profession. However, the attempts fell short of creating a truly independent process. The CICA created this so-called ``independent process,'' which they fund, staff and house. Therefore, it is not an independent body. That is the issue we raise. We believe we need a full public policy debate, not only on the choice of accounting standards, but also on the creation of a fully independent standard-setting process. At present, they are struggling with trying to act as an independent body. The individual may have some independence; the institution does not.
Professor Gaa may wish to add a few comments on their meetings and other issues.
Dr. James C. Gaa, Professor of Accounting, Department of Accounting and Management Information Systems, University of Alberta School of Business: Honourable senators, the establishment of the council was a good idea. It was a positive move. The council is characterized as an independent body. Having sat on that council for several meetings and attended the hearings a couple of weeks ago, I can say that the individuals there are certainly people of character and integrity and I would not criticize them.
The fact remains that the council is a part of the accounting profession, as Mr. Legault was saying. The council is funded and staffed by the institute and reports to it. Although the council was created through nominations from the institute, it now has the power to name new members. Those nominations are recommendations to the institute's board. Again, the council is not independent of the profession in a number of ways.
In order to be more fully independent, the council would have to cut its ties with the profession and become an independent body that obtained funding from other sources. The council could do that. If it did, then it would resemble more closely the standard-setting structures established in other parts of the world.
Senator Angus: At page 8 of your report, at the bottom, you speak about dealing with this audit committee/auditor relationship. You speak about new recommendations from the Assurance Standards Board. Who are they? That is another one. That is not the FASB under another name, is it?
Mr. Legault: That is a committee of the Canadian Institute of Chartered Accountants.
Senator Angus: This is designed to confuse us.
Mr. Gaa: This is a committee of the institute that sets auditing and assurance standards. That committee publishes the rules that govern the process of auditing for chartered accountants.
Senator Furey: In your presentation, you spoke about some of the problems with Enron's audit committee. A number of witnesses have spoken about the independence of audit committees. We also heard that if you were to move in the direction of having an independent auditor associated with the corporation's audit committee, it would be cost prohibitive and, to some degree, repetitive. How do you feel about that?
Mr. Legault: I will respond from a generic standpoint in regard to doing the right thing in trying to exercise leadership. That was the message of the Minister of Finance, Paul Martin, in the speech on May 21 that I referred to earlier.
Many people have been talking about doing the right thing and ensuring that in Canada, we have better standards and higher quality. We fall short of doing the right thing in saying that it will cost money or it will be different from the U.S. I put the question: What do we want to do? We cannot have our cake and eat it too.
Therefore, when it comes to dealing with those questions, we must assess what it will cost and what it will mean, but we must decide what we need to do to protect investors. That should be what drives us.
Mr. Gaa: The traditional role of internal auditors was to work for management and to perform tasks relating to the systems of the business.
When it is contracted out to the auditors, there is a question of for whom they are working and whether they might end up auditing their own work.
One thing that has not been suggested in efforts to make audit committees more effective is to have the internal audit function fall under the board of directors itself, rather than carried out employees of management. If they were under an audit committee of the board of directors, and reported directly to them, it might enhance the governance capabilities of the board, which are limited.
Senator Furey: Corporate audit committees are made up of directors and senior management and are guided by the accounting firm that represents the corporation. Is that not one of the problems?
Mr. Gaa: Was the question about whether the audit committees include management?
Senator Furey: Do they not rely on the accounting firms that are representing the corporations?
Mr. Gaa: They do. Audit committees should not contain members of management, although some do. There are jurisdictions where that is forbidden.
Senator Furey: This is in hindsight, but in looking at the annual reports of Enron now, are all the red flags there to be seen by a trained eye?
Mr. Gaa: I have read in the newspaper that, in hindsight, the information was there and any moderately smart person who read these things could detect it. However, for some reason, many smart people did not. I am not sure how to explain that.
Senator Furey: Do you agree with that assessment?
Mr. Gaa: I have not looked at the statements in sufficient detail to say. I know that some of these arrangements, the special-purpose entities and so on, are extremely complex and difficult to understand. I am not entirely sure why it is so easy, with hindsight, to see all the problems.
The Chairman: We had a witness here, Mr. Gibson of the teachers pension plan in Ontario, who said he read the statements and looked at the footnotes. It was quite obvious to him that there was something wrong and he sold the stock.
Mr. Gaa: There are many puzzles as to why some people see and act. Bre-X is another example.
Senator Meighen: I want to go back to this question of adopting U.S. GAAP or the IASB. As Mr. Caldwell pointed out, our friends south of the 49th parallel do tend to believe that if it is not theirs, it is not as good.
You cited Mr. Volker as having urged the U.S. to move towards international accounting standards. Are there any other trade associations, or other people of his stature, who have made this recommendation, and where do you think the debate lies? The other alternative might be to do nothing, or very little, for a while, pending which way the Americans will go. Another way would be to see if it is possible to exert international pressure on the U.S., although that has never been successful, to adopt the international standards.
It concerns me that if we go with the international rules, even though I would like to emotionally, we will then be left with a set of rules that would be significantly different from the U.S. accounting rules for an indeterminately long period of time.
Mr. Gaa: It may sound acceptable to wait, to see what the U.S. is going to do. Unfortunately, in Canada we have been waiting for that for a long time. A number of Canadian accounting standards have been delayed for years waiting for the U.S., or waiting for changes in other jurisdictions.
Senator Meighen: What has been the cost of that?
Mr. Gaa: We still do not have, and will not have for at least a year, a Canadian standard to account for financial instruments. The U.S. has had one for years, and SEC registrants in Canada follow those rules, while other companies are free to do so.
There is no Canadian standard that prescribes how to measure the value of these financial instruments or how to put them into a financial statement. That has been considered to be a major shortfall in accounting standards for more than 15 years.
Senator Meighen: What position do your cousin organizations, such as the Canadian Institute of Chartered Accountants, take on this matter?
Mr. Legault: The CICA, and I cannot speak on their behalf, I can only look at the facts, through their Accounting Standards Board, has basically pursued a strategy of harmonizing with the U.S., despite the delays involved. We have not heard too much about that recently. There has been some backtracking in trying to do damage control, especially after Enron, by saying that we have the best standards in Canada.
The policy has been to harmonize with the U.S. while trying to move to an international set of standards eventually. They are trying to have their cake and eat it too.
Senator Meighen: Does your association take a different view?
Mr. Legault: Yes, we do.
[Translation]
Senator Hervieux-Payette: On page 7 of your brief, you mention the International Accounting Standards Board, stating that we should move towards it and mentioning three countries — I find this somewhat discouraging — that have adopted these standards. You place us in the same league as Croatia, Cyprus and the Dominican Republic.
Obviously, this does not make for a very solid case in the eyes of a lawyer such as myself, when you say that we will join a club along with Croatia and Cyprus, and that that is the reason for which we are adopting these standards. I can understand that there are countries that have emerging economies, but these are certainly not among the important nations that are recognized for their financial management.
You mention other better-known countries that are also certainly better situated on the international scene, but you also refer to Argentina, which is not in a very healthy state given recent events.
The only argument of substance that you have to convince us to move towards international standards is the one you give on page 19, where you state that it would well serve the interests of SMEs, because it would be easier for them to adapt. Indeed, you state that Canada is a small and medium business economy and that for large companies, it would in any event not be more complicated for them.
SMEs, as far as I know, rarely get financing on American markets. It takes them quite some time before getting there. Our Canadian economy would benefit from this, in your view.
Let us suppose that we take the side of SMEs and opt for International Accounting Standards. First of all, would Canada participate in this process and what would be its role? Is it because it is superior, easier to understand? What is the rationale? Once it has been decided to do this, why go ahead?
Mr. Legault: I could perhaps answer your first question, with regard to the various countries. I believe that what we have to look at is the fact that the European Union decided that in the year 2005 they will allow the application of international standards. That is perhaps the most important element of all. I believe it is on page 9 of our document.
Senator Hervieux-Payette: Yes, but you do not say ``adopt,'' but ``allow.''
Mr. Legault: This will be allowed, as of 2005. Precisely. The situation changes every day. We are seeing that more and more countries are coming on board and, in any event, considerable efforts are being made, in both Canada and the United States, with a view of working with international standards in order that there might be more convergence with the new standards that are being established.
In that regard, considerable work is being done and we believe that given that the European Union is moving in that direction, it will become part of an important block that we will have to join.
The fundamental element that leads us to say that we must move towards international standards is the fact that the philosophy underlying the establishment of standards is a philosophy based on principles and judgment and not on rules, such that it is much easier to move to a system that has the same foundations rather than to a system that is completely different, and that will probably require that we move to yet another system, if we agree that there should be convergence. That is the basis of our argument.
Senator Hervieux-Payette: You are telling me that we are building upon the same basis, that it is closer, but are International Accounting Standards superior to rules? They are not the same, but are they superior?
Is there reason to say that there is more transparency, more precision? There must be something more in order for us to move in that direction. It must not be so vague that everyone adopts it and then in the end we do not wind up with better numbers.
Mr. Legault: In my remarks, I mentioned the CEO of KPMG who talked about establishing or setting better standards. He talked about the ``best of the best.'' There are others in the field who tell us that, yes, these are very good standards. It is not just our own judgment. Quite a few people have contributed to the establishment of these standards. Canadians as well as Americans participated in the setting of international standards. These standards are recognized internationally by the IOSCO, which is the organization that encompasses all of the securities commissions. We are seeing that these standards are precious, and, given that we must move towards global standards, it seems that these are standards that are perfectly acceptable by all.
Senator Hervieux-Payette: The equation is that there would be quality standards and that we would move towards globalization and, thus, that it would be a positive move for Canadian companies to opt for this system rather than for the American rules. Is that the case?
Mr. Legault: Indeed, and that is part of the argument that I mentioned earlier. Everyone is talking about leadership and the way to exercise leadership. Do we exercise leadership solely by following the United States and by moving towards international standards once they have been established? We must be prepared to make the decisions that are required.
[English]
Senator Kelleher: I believe that Senators Meighen and Angus have adequately explored the areas.
[Translation]
Senator Setlakwe: If these international rules are applied and we adopt a position contrary to the one you have set out for SMEs with regard to consultation and auditing, what will happen?
Mr. Legault: What we underscore is the importance at looking at the differences between the companies that are publicly traded and the others.
Senator Setlakwe: However, if there are no international rules disallowing this for all companies, be they small or large, and you want to make a distinction for SMEs, what would happen if there were international rules applying to all companies, and that disallowed consulting and auditing at one and the same time?
Mr. Legault: Within the system, if we decide to adopt international standards, we will nevertheless have to retain an independent organization in Canada to determine if everything should apply or if there should be distinctions made.
[English]
The Chairman: Thank you, gentlemen, for appearing before the committee today.
The committee adjourned.